Draghi Acts: Is It Inflationary?

The European Central Bank (ECB) has decided to bailout its bankrupt members, mainly Italy and Spain, by buying their shorter-term bonds (1 to 3 years) with newly created money. The idea is to drive down their interest rates to alleviate their debt cost burden, and to send a message to the world (the financial markets) that they stand ready to back the euro.

There is a twist here though. The European Central Bank will seek to "sterilize" the funds it injects into the economy by withdrawing an equal amount of money from the economy. They do this by offering banks one week deposit certificates at the same rate as overnight money. Thus the idea is that this will effectively render the new money inflation neutral.

The head of the Bundesbank, Jens Weidmann, was the only nay vote for this new program, termed Outright Monetary Transactions (OMT) to distinguish it from QE. He is quoted as saying OMT is “tantamount to financing governments by printing banknotes.” Shmart fellow, he. It seems the Germans are the only ones in Europe who seem to understand what money is.

Here's how sterilization works. The ECB will buy as many sovereign bonds as it sees fit to drive down short-term bond rates. It creates new money to buy these bonds from banks. The banks now hold a lot of cash equal to the ECB bond buys. At the same time the ECB will sell to the same banks one-week notes to suck up the same amount of new money it created for the bond buys. The net effect: the ECB has removed €x billion of sovereign bonds from the market. They have also removed the same amount of money from the money supply and these banks now own one-week ECB notes instead of 1 to 3 year sovereign bonds. If the ECB does this often enough it will drive interest rates down because bond investors know that they ECB stands ready, willing, and able to do this. Why fight the ECB (or the Fed)?

The obvious impact of this move will be to create joy among banks holding mainly Spanish and Italian debt. They have exchanged a risky asset for a more stable asset (ECB paper). Readers will recall that sovereign debt of any EMU country is counted as a Tier 1 asset for member banks. Thus Greek debt is equal to German Bunds in the regulators eyes. We all know that is not true and so do the banks' depositors.

Because of the ongoing recession in most of the Eurozone, lending has shrunk, so banks aren't doing much with their reserves anyway. According to this report, these banks are holding €770 billion in excess reserves. Now they will have even more reserves when the ECB get through with its open-ended OMT. These could be another €640 billion of OMT purchases and these will no doubt also end up as sterilized excess reserves.

This creates a bit of a problem. For one thing, the balance sheets of banks for purposes of calculating reserves haven't really changed by exchanging sovereign bonds for ECB notes. It is still Tier 1 capital and it will still be held as excess reserves. If loan demand kicks up, will the ECB be able to restrain its banks? We have the same problem here.

The other thing is that everyone knows that because there is no fiscal union, but only a monetary union, the Germans are the only ones with the money to finance the debt of its fellow profligate states. By giving Spain and Italy interest rate relief, the Germans are worried that their zeal for reform will wane and stick Germany with their bill. Think of it as a debt union rather than a monetary union. As Bundesbank head Weidmann said:

When the central banks of the euro area buy the sovereign bonds of individual countries, these bonds end up on the Eurosystem’s balance sheet. Ultimately, it’s the taxpayers of all other countries who are liable for that. In democracies, parliaments ought to decide on such a far-reaching mutualisation of risks, not the central banks.

Then what if Spain and Italy fail to carry out the agreed to reforms that condition the implementation of OMT? Let's say they go along with massive bond purchases and, say Italy, fails to meet its conditions to funding? Would they then liquidate their bond portfolio and let the chips fall where they may? Not likely.

As Herr Weidmann said, this kind of bailout is "too close" to central-bank financing of government deficits "with a printing press." He is right; history has shown that this is a slippery slope as the Germans should know. This program will give little lasting relief to the Eurozone's problems, and it may delay reforms as domestic political pressures could easily change the scenario. And I believe at some point they have three choices: allow countries to go bankrupt; dissolve the EMU; print money. My vote is for the latter. Of course the miracle of political and economic reform is a possibility if the Germans have their way, but don't count on it.

Despite the overwhelming evidence that money printing doesn't work, the Eurozone overlords will to do it anyway. Why do they do this? Monetary inflation is the last resort of governments who are over their heads in debt. Instead of going bankrupt (there is no way we or the overindebted Eurozone countries can repay the debt) they make the debt cheaper to pay off by inflating the money supply. It's an age-old last resort of incompetent rulers.

It will be inflationary down the line (it already is for the average person food, gas, etc) but that's the thing people might want to consider who will make all that money when they raise the interest rates on all the government debt!

Look, they are all printing, the Fed, the ECB, to prop up the status quo and prevent a deflation. Asset values (collateral) are falling, so to keep the banks from getting nervous and pulling credit lines on each other central banks are dousing them in cash. If banks are liquid they dont get scared. And when banks get scared, they get mean.

The ECB will buy as many sovereign bonds as it sees fit to drive down short-term bond rates. It creates new money to buy these bonds from banks.

The ECB will LEND, accepting as collateral as many sovereign bonds as it sees fit to accept. The ECB is a BANK, not Santa Claus.

The ECB creates new CREDIT to obtain bonds from the banks. It does so by making ledger entries in the accounts of its bank-clients. It is absolutely constrained by the availability of good collateral.

If there is no good collateral (fraudulent collateral) any ECB loan is a BAD LOAN on its face, if there is defective collateral the ECB loan is an instant loss, a BAD LOAN and the ECB is insolvent.

The ECB is taking over the private sector's role in offering credit to sovereigns. As such it is a 'front' for the private sector (which funnels funds to sovereigns by way of the ECB).

The ECB loans are still loans, they must be repaid. Discount window operations tend to be very short-term: no word about repayment of loans from ECB.

If the ECB does not specify repayment it has no credibility. If it specifies repayment terms the exercise is pointless. The borrowers are all bankrupt, they need grants, not loans. However, the ECB is a bank, it offers loans only ... not grants. It can offer secured loans only (otherwise it becomes instantly insolvent as it has little capital and cannot absorb a loss).

Meanwhile, the 'ECB sterilization' is a play on words. The ECB cannot afford to return any of its own inventory to the marketplace: these worthless bonds in the marketplace are why there is a crisis in the first place!

What is more likely is an accelerating run out of European banks. There is no more last line of defense for them.

Credit is money in a fiat system. This "credit" is created ex nihilo. Where the borrower had an asset, he now has cash (credit) -- to buy more sovereign debt? The effect is to creat artificial demand for sovereign debt and thus artifically suppress ates. Same game Bennie's been playing. Anyway you "sanitize" or spin it, it is debt monetization and bubble blowing.

And what Econophile doesn't get is that Germany is going along, to make sure there is not a collapse in German banks, insurers and pension funds, all linked in daisy-chains to the GIIPS debt ...

And the reason the euro will stay strong, even as some of the Club Med countries are poised to exit and fragment the euro-zone, is that Continental Europe is still the richest, best-off sector of the world

- We have no trade deficit, we grow food, we have industry, we are self-sufficient once Russian energy is included

- We have 3x the bank deposits of the USA, despite similar size economy (about 1/4 of global GDP)

- We owe the money to ourselves, not foreign creditors, we can play games with the debt and write it off if we must

- We still have a functioning legal system that protects human rights, with almost no one in jail in Continental Europe, and no crooked judges like in the US helping steal billions in private bank accounts and putting millions of people in a gulag

- We have the biggest gold reserves in the world

- Our North-West Continental Europe is still the nicest place to live on the globe

- We have no trade deficit, we grow food, we have industry, we are self-sufficient once Russian energy is included

1. Not having a trade deficit does NOT mean you are self sufficient (where does all

the uranium / iron ore / aluminium etc come from ?)

2. As the euro short selling lemmings seem to fall of the cliff again after about just 1 year ago another horde did it (they never seem to learn it ); how long will we have industry if the dollar would REALLY go down this time ?

Our North-West Continental Europe is still the nicest place to live on the globe

Definetly not if you prefer a warmer climate, much less population density and also

do not want to drive on narrow roads in cities that were built more then 500 years

The dollar will simply be replaced by the next "Reserve Currency". Right now most bets seem to be on this being the Yuan, butwith China facing a rocky road ahead this is obviously no sure thing.

Narrow roads encourage energy efficient forms of transport - such as rail. Smaller compact cities (a characteristic of 500 year old development) encourage use of self-propelled transport = exercise = a fitter population. They also have the character and history missing in the more modern cities.

Higher population density allows greater economies of scale, and more efficient private or public service provision. It also encourages more space / energy / resources efficient design and use of available space - good example being Holland - VERY high population density but abundant green spaces / rural space, due to the acceptance of QUALITY high density accommodation, and people take a PRIDE in their Communities, with a very evident high degree of social cohesion.

Countries such as America, Canada and Australia really need to learn the lessons of being far more efficient - "Bigger" is NOT "Better" and comparing the "Best Housing in the World" mass produced shoddily built Australian crap (currently renting in outer Melbourne) with what I owned in Amersfoort, I'll take my small home anyday.